Correction on the stock market - warning signal or market noise?

The start to August could hardly have been more turbulent. The first few trading days were characterised by a real slump on the stock markets, presumably accelerated by leveraged positions, trend-following algorithms and the forced unwinding of mass yen carry trades. Although the situation seems to have calmed down again in the meantime, we believe that investors should not be lulled into a false sense of security and should therefore not neglect the defensive side of the market.

The USA and Japan at the centre of events

Many market participants cited the weak labour market report from the USA, with the number of new non-farm jobs created falling far short of expectations, as the trigger. This in turn fuelled fears of recession and led to falling yield levels along the US yield curve. On the other side of the Pacific, the Japanese central bank raised its key interest rate by 25 basis points a few days earlier, which led to an appreciation of the Japanese yen. It is assumed that the convergence of the yield differential between the USA and Japan, combined with the rapid appreciation of the JPY against the USD and the fall in global share prices, led to a panic-like unwinding of the yen carry trade and thus further accelerated the sell-off. Whether this was actually the case is hard to prove. However, a certain influence of technical factors is obvious.

What is certain is that the first signs of a correction on the stock market were already recognisable a few weeks earlier. The technology and communication services sectors in particular, which had previously driven the market significantly higher, were the first to be affected by price falls. NVIDIA shares, for example, had already peaked on 20 June and had lost more than 30% of their value by the time they bottomed out on 5 August. On the other hand, more defensive stocks such as utilities, REITs and healthcare stocks provided a certain degree of stability.

Total return of selected sectors*, in euros (%)
Past performance is not a guide to future performance.

Source: Morningstar, 13 August 2024. *Sectors based on the MSCI ACWI Index.

The correction therefore appears to have been triggered by a combination of several aspects, including a revaluation of technology stocks, which are often sporty in terms of valuation, increasing recession worries in the USA and the technical factors described above.

A change in market narrative within a very short period of time

It is quite remarkable how quickly sentiment and the narrative for the US economy can change - from ‘soft landing’ to recession and back again. The change in the narrative can be recognised not only by the general fall in share prices but also by the change in the interest rate hikes that have been priced in. At the peak of market volatility on 5 August, over 130 basis points of interest rate cuts by the US Fed were priced in by the December meeting, which would require an aggressive interest rate cut of at least 50 basis points. Such monetary easing would ultimately only be expected if the central bank wanted to counteract a recession. Just two weeks later, the extent of the priced-in interest rate cuts has fallen to below 100 basis points.

How justified are the recession fears for the USA?

In our view, a certain slowdown in the US economy has been foreseeable for some time. After all, the restrictive monetary policy in the form of higher interest rates only takes effect after some delay. The fact that consumption has remained so robust over the past 12 months is probably due to excess savings. However, these could soon be exhausted. A reduction in consumer activity, which is ultimately responsible for almost 70 % of economic output in the US, would therefore not really come as a surprise. Only recently, several large companies from the consumer sector also noted a noticeable slowdown in consumption in the US. US home improvement giant Home Depot, for example, warned that sales in the second half of the year are likely to be weaker than expected due to increasing caution on the part of US consumers. On the other hand, retail sales in the US appear to have even accelerated recently, which has surprised many market participants. There can therefore be no question of a widespread slump in consumption.

The purchasing managers' indices are often used as important leading indicators. These are currently providing mixed signals. Two data providers are available for the USA - S&P Global and ISM. The good news is that both purchasing managers' indices for the services sector for July are still above the critical fifty mark and thus point to an upturn. The bad news is that the manufacturing sector indices are both below this threshold, signalling a downturn. However, in view of the fact that the service sector has a much greater weight in the US economy, the glass appears to be half full rather than half empty from this perspective.

As far as the labour market is concerned, the disappointing number of new jobs created signals a certain slowdown in hiring, but no major waves of layoffs have yet been observed. New applications for unemployment benefits remain at a low level (as at 8 August 2024). The labour market is cooling somewhat, but from a fairly overheated level.

Don't panic, but don't let your guard down

To summarise, the US economy appears to be losing some momentum, but not yet to a dramatic extent. The relatively strong market reaction in the first week of August was therefore possibly simply due to market participants' lack of concern, accelerated by the technical factors mentioned above. Nevertheless, the recent correction should be seen as a warning not to let your guard down.

On the equity side, this means diversifying broadly and not focussing too one-sidedly on the hottest momentum stocks from the USA, for example. In particular, the inclusion of defensive equity segments, such as infrastructure or healthcare stocks, could make sense in view of the increasing uncertainties. REITs could also benefit from potentially falling yield levels. In our view, valuations should not be disregarded either. In contrast to the popular growth stocks, recession-like scenarios are already priced into a large number of favourably valued value stocks. We believe the downside potential of such stocks should therefore be reduced.

The value of the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. The views expressed in this document should not be taken as a recommendation, advice or forecast.